Profits, Purpose, and Payday Lending

On May 23, the Office of the Comptroller of the Currency (OCC) issued a bulletin allowing national banks into the short-term, small dollar lending often stigmatized as payday lending. The policy shift is intended to spur regulated banks into a business prone to predatory practice, thus giving vulnerable borrowers a better way to tide them over short-term financial hardships. Will banks start making short-term, small-dollar loans now that they have the OCC’s blessing? Not if they can’t find a way to make money.

The strictures included in the bulletin designed to protect vulnerable customers combine with prudential requirements to make payday substitutes an unprofitable proposition. Banks will thus stick to more costly overdraft products unless these are outlawed – unlikely, new rules blow up the business model that profits non-bank payday lenders – also unlikely, or the government steps in – the Post Office? A better way is to craft a short-term loan product under a far more complete package of rules that preserves at least a bit of profit to encourage banks to make at least a few short-term loans.

Are banks evil-minded, putting profit above purpose? This theological question often gets a thoroughly political answer, but here’s an agnostic fact: banks are for-profit private corporations and thus can only do the public’s bidding when it profits them to do so. The traditional divide in a free-market economy is that private firms ensure market efficiency, rules prevent efficiency from doing avoidable damage to equity, and the government steps in where private capital fears to tread.

Why will it be so hard for national banks to do both good and well in payday-style products? First come the capital rules, which will impose significant cost on these loans, especially those from the largest banks subject to the advanced approach and CCAR. Unregulated payday lenders are of course exempt from capital regulation, thus giving them a pricing edge from the start. The OCC’s valiant effort to protect consumers then further differentiates bank from non-bank payday lending.

Under the new standards, national banks must, for example, charge “reasonable” rates, which many interpret as no more than 36% a year. This sounds mighty high, but it’s actually a small amount on loans that are not only short-term and small-dollar, but also high-cost above and beyond the capital rules. The main reason for these add-on high costs is underwriting and systems costs of loans that are also short-term and small-dollar – it doesn’t cost much more to do a $10,000 loan than the $100 or so many payday borrowers need, but the bigger loan of course generates considerably more interest and fee revenue.

The OCC also and understandably wants national banks to ensure that problem payday-substitute loans are serviced to protect the borrower – a complex, loan-by-loan work-out that significantly increases the cost of all of the loans that don’t go bad to pay for those that do. In a payday-like business, that’s going to be a lot of loans – hence the high capital charges with which I started.

So, commendable try from the OCC, but one that will do little to threaten the hegemony of finance companies not subject to all these niceties. What could the government do? Nothing easy, but two options are at hand.

First, the OCC should go on from the current guidance to allow limited regulatory-capital relief for eligible short-term, small-dollar loans. Setting a small percentage of total assets in this sector and then giving them an out from the advanced approach in concert with a sensible standardized rule would open a bit of balance-sheet capacity. It isn’t risky. Not only are total loan balances limited, but all of the loans are to different people and thus far less correlated than a few giant loans to a couple of very rich people. Favorable risk weightings are also disciplined by the leverage ratio.

Second, the federal government could create a guarantee facility for loans to individuals caught short between paydays – think of it as sort of an emergency-liquidity facility for people, not banks. As our last blog post showed, guarantees are a fiscally-efficient way to use federal dollars for public purpose. The tricky bit is ensuring also that the guarantee is well designed to prevent dangerous incentive misalignment – see the FHA example in the blog post as a costly case in point. The guarantee must also be structured so that regulated institutions can profitably avail themselves of it. If they can’t, then the odds for significant taxpayer losses increase beyond those sure to come even with a well-designed, incentive-aware guarantee.

Could the U.S. Postal Service step in? New legislation authorizing USPS to offer these loans (S. 2755) sure hopes so. However, as another recent blog post showed, the USPS would take on all of the financial risks that cause the bank capital requirements to be as high as they are. Add in the consumer protections sure to be required of a quasi-government agency, and USPS’s costs go even higher. It’s simply very hard to do short-term, small-dollar loans at a profit unless interest rates are very high, fees add to these punitive rates, and consumer protections are put aside.